x QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September
30, 2017

OR

o TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from __________
to __________.

Commission file number 001-31972

TELKONET, INC.

(Exact name of Registrant as specified in
its charter)

Utah

87-0627421

(State or Other Jurisdiction of Incorporation or Organization)

(I.R.S. Employer
Identification No.)

20800 Swenson Drive, Suite 175, Waukesha, WI

53186

(Address of Principal Executive Offices)

(Zip Code)

(414) 302-2299

(Registrant’s Telephone Number, Including
Area Code)

Indicate
by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act
during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days. Yes x No
¨

Indicate
by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the
preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No
¨

Indicate by check mark
whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company,
or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller
reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o(Do not check if a smaller reporting company)

Smaller reporting company x

Emerging growth company o

If
an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for
complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate
by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. Yes o No
x

The number of shares
outstanding of the registrant’s common stock, par value $0.001 per share, as of October 31, 2017 is 133,440,111.

Series A, par value $.001 per share; 215 shares issued, 185 shares outstanding at September 30, 2017 and December 31, 2016, preference in liquidation of $1,507,481 and $1,452,114 as of September 30, 2017 and December 31, 2016, respectively

1,340,566

1,340,566

Series B, par value $.001 per share; 538 shares issued, 52 shares outstanding at September 30, 2017 and December 31, 2016, preference in liquidation of $409,009 and $393,435 as of September 30, 2017 and December 31, 2016, respectively

See accompanying notes to the unaudited
condensed consolidated financial statements

6

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS (Continued)

(UNAUDITED)

Nine Months Ended

September 30,

2017

2016

Supplemental Disclosures of Cash Flow Information:

Cash transactions:

Cash paid during the period for interest

$

11,485

$

30,980

Cash paid during the period for income taxes, net of refunds

58,551

–

Schedule of Non-Cash Investing Activities:

Unpaid purchases of property and equipment included in accounts payable

$

66,693

–

See accompanying notes to the unaudited
condensed consolidated financial statements

7

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

NOTE A – BASIS OF PRESENTATION
AND SIGNIFICANT ACCOUNTING POLICIES

A summary of the significant accounting
policies applied in the preparation of the accompanying condensed consolidated financial statements follows.

General

The accompanying unaudited condensed consolidated
financial statements of Telkonet, Inc. (the “Company”, “Telkonet”) have been prepared in accordance with
Rule S-X of the Securities and Exchange Commission (the “SEC”) and with the instructions to Form 10-Q. Accordingly,
they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial
statements.

In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair presentation have been included. However, the results
from operations for the nine months ended September 30, 2017, are not necessarily indicative of the results that may be expected
for the year ending December 31, 2017. The unaudited condensed consolidated financial statements should be read in conjunction
with the consolidated December 31, 2016 financial statements and footnotes thereto included in the Company's Form 10-K filed with
the SEC.

Business and Basis of Presentation

Telkonet, formed in 1999 and incorporated
under the laws of the state of Utah, is the creator of the EcoSmart Platform of intelligent automation solutions designed to optimize
energy efficiency, comfort and analytics in support of the emerging Internet of Things (“IoT”).

In 2007, the Company acquired substantially
all of the assets of Smart Systems International (“SSI”), which was a provider of energy management products and solutions
to customers in the United States and Canada and the precursor to the Company’s EcoSmart platform. The EcoSmart platform
provides comprehensive savings, management reporting, analytics and virtual engineering of a customer’s portfolio and/or
property’s room-by-room energy consumption. Telkonet has deployed more than a half million intelligent devices worldwide
in properties within the hospitality, military, educational, healthcare and other commercial markets. The EcoSmart platform is
rapidly being recognized as a leading solution for reducing energy consumption, operational costs and carbon footprints, and eliminating
the need for new energy generation in these marketplaces – all while improving occupant comfort and convenience.

On March 28, 2017, the Company, and the
Company’s wholly-owned subsidiary, EthoStream LLC, a Wisconsin limited liability company (“EthoStream”), entered
into an Asset Purchase Agreement (the “Purchase Agreement”) with DCI-Design Communications LLC (“DCI”),
a Delaware limited liability company, whereby DCI would acquire all of the assets and certain liabilities of EthoStream for a base
purchase price of $12,750,000. The Purchase Agreement provided that proceeds of $900,000 were to be withheld from the $12,750,000
base purchase price and placed into an escrow account to support potential indemnification obligations of up to $800,000 and net
working capital adjustments of up to $100,000. Another $93,000 is classified in other current assets as a net working capital receivable.
The escrow amount, net of potential claims, will be fully released after an escrow period not to exceed 12 months after closing.
The assets included, among other items, certain inventory, contracts and intellectual property. DCI acquired only the liabilities
provided for in the Purchase Agreement. On March 29, 2017, pursuant to the terms and the conditions of the Purchase Agreement,
the Company closed on the sale. The income from discontinued operations (net of tax) represents the activity of EthoStream
from January 1, 2017 through the date of the sale on March 28, 2017. The gain from sale of discontinued operations (net of tax)
represents the gain recognized from the EthoStream selling price that was in excess of the assets sold to DCI and liabilities assumed
by DCI on March 28, 2017. On September 27, 2017, the Company reached a final settlement with DCI on net working capital as set
forth in the Purchase Agreement. On September 29, 2017, the Company received $100,000 from the escrow account for the portion of
the escrow account set aside for net working capital adjustments and cash proceeds of $311,000 from DCI in the settlement of net
working capital adjustments. The net working capital receivable of $93,000 in other current assets was applied against the cash
proceeds of $311,000 received on September 29, 2017 resulting in a gain from sale of discontinued operations of $218,000 recognized
during the three months ended September 30, 2017.

8

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

The condensed consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiaries, Telkonet Communications, Inc., and EthoStream. The current
and prior period accounts of Ethostream have been classified as discontinued operations on the condensed consolidated balance sheet,
the condensed consolidated statement of operations and the condensed consolidated statement of cash flows. All significant intercompany
balances and transactions have been eliminated in consolidation.

The Company reported a net loss of $3,034,984
from continuing operations for the nine months ended September 30, 2017, had cash used in operating activities from continuing
operations of $2,459,746 and had an accumulated deficit of $119,301,087. Since inception, the Company’s primary sources of
ongoing liquidity for operations have come through private and public offerings of equity securities, and the issuance of various
debt instruments, asset-based lending and the sale of assets.

On March 29, 2017, an amendment to the
revolving credit facility with Heritage Bank of Commerce, a California state chartered bank (“Heritage Bank”), was
executed to amend certain terms of the Loan and Security Agreement (the “Heritage Bank Loan Agreement”) following the
sale of certain assets of the Company’s wholly-owned subsidiary, EthoStream. Heritage Bank amended the EBITDA compliance
measurement.

On October 23, 2017, an amendment to the
revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the
terms of the amendment was that if the Company deviates from its projected EBITDA for the quarters ended September 30, 2017 or
December 31, 2017, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted
cash maintained at Heritage Bank is in excess of $5,000,000. The amendment also extends the revolving credit facility’s maturity
date by one year to September 30, 2019.

The outstanding balance of the revolving
credit facility was $79,953 as of September 30, 2017 and the remaining available borrowing capacity was approximately $1,304,000.
As of September 30, 2017, the Company was in compliance with all financial covenants.

On
March 28, 2017, the Company and EthoStream, entered into the Purchase Agreement with DCI whereby DCI acquired all of the assets
and certain liabilities of EthoStream for a base purchase price of $12,750,000, subject to an adjustment based on the net working
capital of EthoStream on the closing date of the sale transaction. The Company’s liquidity for the remainder of 2017 remains
strong due to the net proceeds received from the sale of EthoStream.

Restricted Cash on Deposit

The
restricted cash on deposit of $800,000 as of September 30, 2017 reflects amounts placed into an escrow account to support potential
indemnification obligations associated with the sale of the Company’s wholly-owned subsidiary, EthoStream. The escrow amount,
net of potential claims, would be fully released after an escrow period not to exceed 12 months from the transaction closing on
March 29, 2017. On September 29, 2017, the Company received $100,000 from the escrow account for the portion of the escrow account
set aside for net working capital adjustments.

9

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

Income (Loss) per Common Share

The Company computes earnings per share
under ASC 260-10, “Earnings Per Share”. Basic net income (loss) per common share is computed using the treasury stock
method, which assumes that the proceeds to be received on exercise of outstanding stock options and warrants are used to repurchase
shares of the Company at the average market price of the common shares for the year. Dilutive common stock equivalents consist
of shares issuable upon the exercise of the Company's outstanding stock options and warrants. For the nine months ended September
30, 2017 and 2016, there were 5,621,800 and 2,240,225 shares of common stock underlying options and warrants excluded due to these
instruments being anti-dilutive, respectively.

Use of Estimates

The preparation of financial statements
in conformity with United States of America (U.S.) generally accepted accounting principles (“GAAP”) requires management
to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure
of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses
during the reporting period. Estimates are used when accounting for items and matters such as revenue recognition and allowances
for uncollectible accounts receivable, inventory obsolescence, depreciation and amortization, long-lived assets, taxes and related
valuation allowance, income tax provisions, stock-based compensation, and contingencies. The Company believes that the estimates,
judgments and assumptions are reasonable, based on information available at the time they are made. Actual results may differ from
those estimates.

Income Taxes

The Company accounts for income taxes in
accordance with ASC 740-10 “Income Taxes.” Under this method, deferred income taxes (when required) are provided based
on the difference between the financial reporting and income tax bases of assets and liabilities and net operating losses at the
statutory rates enacted for future periods. The Company has a policy of establishing a valuation allowance when it is more likely
than not that the Company will not realize the benefits of its deferred income tax assets in the future.

The Company adopted ASC 740-10-25, which
prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position
taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on derecognition, classification, treatment
of interest and penalties, and disclosure of such positions.

Revenue Recognition

For revenue from product sales, the Company
recognizes revenue in accordance with ASC 605-10, “Revenue Recognition” and ASC 605-10-S99 guidelines that require
that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery
has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria
(3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered
and the collectability of those amounts. Assuming all conditions for revenue recognition have been satisfied, product revenue
is recognized when products are shipped and installation revenue is recognized when the services are completed. Provisions for
discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period
the related sales are recorded. The guidelines also address the accounting for arrangements that may involve the delivery or performance
of multiple products, services and/or rights to use assets.

10

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

Multiple-Element Arrangements (“MEAs”):
The Company accounts for contracts that have both product and installation under the MEAs guidance in ASC 605-25. Arrangements
under such contracts may include multiple deliverables consisting of a combination of equipment and services. The deliverables
included in the MEAs are separated into more than one unit of accounting when (i) the delivered equipment has value to the
customer on a stand-alone basis, and (ii) delivery of the undelivered service element(s) is probable and substantially in
the Company’s control. Arrangement consideration is then allocated to each unit, delivered or undelivered, based
on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”)
if it exists, second on third-party evidence (“TPE”) if it exists and on estimated selling price (“ESP”)
if neither VSOE or TPE exist.

•

VSOE – In most instances, products are sold separately in stand-alone arrangements. Services are also sold separately through renewals of contracts with varying periods. The Company determines VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s).

•

TPE – If the Company cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, the Company uses third-party evidence of selling price. The Company determines TPE based on sales of a comparable amount of similar product or service offered by multiple third parties considering the degree of customization and similarity of product or service sold.

•

ESP – The estimated selling price represents the price at which the Company would sell a product or service if it were sold on a stand-alone basis. When neither VSOE nor TPE exists for all elements, the Company determines ESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on the Company’s pricing practices. Adjustments for other market and Company-specific factors are made as deemed necessary in determining ESP.

Under the estimated selling price method,
revenue is recognized in MEAs based on estimated selling prices for all of the elements in the arrangement, assuming all other
conditions for revenue recognition have been satisfied. To determine the estimated selling price, the Company establishes
the selling price for its products and installation services using the Company’s established pricing guidelines, and the
proceeds are allocated between the elements and the arrangement.

When MEAs include an element of customer
training, the Company determined it is not essential to the functionality, efficiency or effectiveness of the MEA due to its perfunctory
nature in relation to the entire arrangement. Therefore the Company has concluded that this obligation is inconsequential and perfunctory.
As such, for MEAs that include training, customer acceptance of said training is not deemed necessary in order to record the related
revenue, but is recorded when the installation deliverable is fulfilled. Historically, training revenues have not been significant.

The Company provides call center support
services to properties installed by the Company. The Company receives monthly service fees from such properties for its services.
The Company recognizes the service fee ratably over the term of the contract. The prices for these services are fixed and determinable
prior to delivery of the service. The fair value of these services is known due to objective and reliable evidence from standalone
executed contracts. The Company reports such revenues as recurring revenues. Deferred revenue includes deferrals for
the monthly support service fees. Long-term deferred revenue represents support service fees to be earned or provided beginning
after September 30, 2018. Revenue recognized that has not yet been billed to a customer results in an asset as of the end of the
period. As of September 30, 2017 and December 31, 2016, there was $68,855 and $193,400 recorded within accounts receivable, respectively,
related to revenue recognized that has not yet been billed.

11

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

Guarantees and Product Warranties

The Company records a liability for potential
warranty claims in cost of sales at the time of sale. The amount of the liability is based on the trend in the historical ratio
of claims to sales, the historical length of time between the sale and resulting warranty claim, new product introductions and
other factors. The products sold are generally covered by a warranty for a period of one year. In the event the Company determines
that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves would be
charged to earnings in the period such determination is made. For the nine months ended September 30, 2017 and the year ended December
31, 2016, the Company experienced returns of approximately 1.0% to 2.5% of materials included in the cost of sales. As of September
30, 2017 and December 31, 2016, the Company recorded warranty liabilities in the amount of $77,810 and $95,540, respectively, using
this experience factor range.

Product warranties for the nine months
ended September 30, 2017 and the year ended December 31, 2016 are as follows:

September 30, 2017

December 31, 2016

Beginning balance

$

95,540

$

66,555

Warranty claims incurred

(48,767

)

(115,120

)

Provision charged to expense

31,037

144,105

Ending balance

$

77,810

$

95,540

Reclassifications

Certain amounts on the condensed consolidated
balance sheets as of December 31, 2016 and statements of cash flows have been reclassified to conform to the current year presentation.
The Company reclassified $106,743 from current assets of discontinued operations to cash and cash equivalents for certain EthoStream
assets not sold to DCI on March 28, 2017. The Company reclassified $150,936 from current liabilities of discontinued operations
to accrued liabilities and expenses for certain EthoStream liabilities not assumed by DCI on March 28, 2017. The reclassifications
were not material and had no effect on the Company’s total current assets, current liabilities or stockholders’ equity
as of December 31, 2016.

NOTE B – NEW ACCOUNTING PRONOUNCEMENTS

In May 2014, the
Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue
from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP.
The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount
that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five
step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition
process than are required under existing U.S. GAAP. The guidance for this standard was initially effective for annual reporting
periods beginning after December 15, 2016, including interim periods within that reporting period, however in August 2015 the FASB
delayed the effective date of the standard for one full year. Companies will adopt the standard using either of the following transition
methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option
to elect certain practical expedients, or (ii) a modified retrospective approach with the cumulative effect of initially adopting
ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). The Company expects to adopt ASU
2014-09 as of January 1, 2018 with a cumulative effect adjustment to opening retained earnings, if necessary, under the modified
retrospective approach. The Company has developed a project plan for the implementation of the new standard including a review
of all revenue streams to identify any differences in the performance obligations, timing, measurement or presentation of revenue
recognition. The Company’s implementation of this ASU includes the evaluation of its customer agreements to identify terms
or conditions that could be considered a performance obligation such that, if material to the terms of the contract, consideration
would be allocated to the performance obligation and could accelerate or defer the timing of recognizing revenue. The Company
also continues to evaluate the presentation of its principal versus agent arrangements. The Company’s evaluation of its revenue
streams and the treatment under the new guidance on the timing of revenue recognition and the allocation of revenue to the
Company’s goods and services is in process and any effect cannot be determined at this time.

12

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

In February 2016, the FASB issued
ASU No. 2016-02, Leases (“ASU 2016-02”). The new standard establishes a right-of-use (ROU) model that requires a lessee
to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be
classified as either finance or operating, with classification affecting the pattern of expense recognition in the statement of
operations. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those
fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at,
or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical
expedients available. The Company is currently evaluating the impact of its pending adoption of ASU 2016-02 on its consolidated
financial statements. Upon adoption, the Company expects that the ROU asset and lease liability will be recognized in the balance
sheets in amounts that will be material.

In August 2016, the FASB issued ASU No.
2016-15, Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). The new standard provides
guidance on the classification of certain transactions in the statement of cash flows, such as contingent consideration payments
made in connection with a business combination and debt prepayment or extinguishment costs. ASU 2016-15 is effective for fiscal
years beginning after December 15, 2017, including interim periods within that fiscal year. When adopted, the new guidance will
be applied retrospectively. The Company is currently evaluating the impact of its pending adoption of ASU 2016-15 on its consolidated
financial statements.

In May 2017, the FASB issued ASU 2017-09,
Compensation — Stock Compensation — Scope of Modification Accounting (“ASU 2017-09”), which provides guidance
about the types of changes to terms or conditions of a share-based payment award that would require an entity to apply modification
accounting. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within
those fiscal years. Early adoption is permitted. The amendments in this update should be applied prospectively to an award modified
on or after the adoption date.

NOTE C– ACCOUNTS RECEIVABLE

Components of accounts receivable as of September 30, 2017 and
December 31, 2016 are as follows:

September 30, 2017

December 31, 2016

Accounts receivable

$

1,781,394

$

1,438,345

Allowance for doubtful accounts

(12,173

)

(34,573

)

Accounts receivable, net

$

1,769,221

$

1,403,772

NOTE D – ACCRUED LIABILITIES AND EXPENSES

Accrued liabilities and expenses at September 30, 2017 and December
31, 2016 are as follows:

September 30, 2017

December 31, 2016

Accrued liabilities and expenses

$

589,288

$

223,011

Accrued payroll and payroll taxes

354,293

331,908

Accrued sales taxes, penalties, and interest

72,331

274,869

Accrued interest

332

253

Product warranties

77,810

95,540

Total accrued liabilities and expenses

$

1,094,054

$

925,581

13

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

NOTE E – DEBT

Kross Promissory Note

On August 4, 2016, the Board of Directors
authorized the Company to reimburse Peter T. Kross (“Mr. Kross”) $161,075 for expenses incurred related to his successful
contested proxy. Effective June 27, 2016, Mr. Kross became a director of the Company and is considered a related party. On August
30, 2016, Mr. Kross accepted an unsecured promissory note (“Kross Note”) for $161,075 from the Company. The outstanding
principal balance bore interest at the annual rate of 3.00%. Payment of interest and principal began on September 1, 2016 and continued
monthly on the first day of each month thereafter through and including June 1, 2017. The Company was required to pay equal monthly
installments of $16,330 which included all remaining principal and accrued interest owed by the Company to Mr. Kross under the
Kross Note. The Company could prepay in advance any unpaid principal or interest due under the Kross Note without premium or penalty.
The principal balance of the Kross Note as of September 30, 2017 and December 31, 2016 was zero and $97,127, respectively.

Revolving Credit Facility

On September 30, 2014, the Company and
its wholly-owned subsidiary, EthoStream, as co-borrowers (collectively, the “Borrowers”), entered into a loan and security
agreement (the “Heritage Bank Loan Agreement”), with Heritage Bank of Commerce, a California state chartered bank (“Heritage
Bank”), governing a new revolving credit facility in a principal amount not to exceed $2,000,000 (the “Credit Facility”).
Availability of borrowings under the Credit Facility from time to time is subject to a borrowing base calculation based on the
Company’s eligible accounts receivable and eligible inventory each multiplied by an applicable advance rate, with an overall
limitation tied to the Company’s eligible accounts receivable. The Heritage Bank Loan Agreement is available for working
capital and other general business purposes. The outstanding principal balance of the Credit Facility bears interest at the Prime
Rate plus 3.00%, which was 7.25% at September 30, 2017 and 6.75% at December 31, 2016. On October 9, 2014, as part of the Heritage
Bank Loan Agreement, Heritage Bank was granted a warrant to purchase 250,000 shares of Telkonet common stock. The warrant has an
exercise price of $0.20 and expires October 9, 2021. On February 17, 2016, an amendment to the Credit Facility was executed extending
the maturity date to September 30, 2018, unless earlier accelerated under the terms of the Heritage Bank Loan Agreement.

The Heritage Bank Loan Agreement also contains
financial covenants that place restrictions on, among other things, the incurrence of debt, granting of liens and sale of assets.
The Heritage Bank Loan Agreement and amendments also contain financial covenants that require the Borrowers to maintain a minimum
EBITDA level, measured quarterly, a minimum asset coverage ratio, measured monthly and minimum cash account balances. A violation
of any of these covenants could result in an event of default under the Heritage Bank Loan Agreement. Upon the occurrence of such
an event of default or certain other customary events of defaults, payment of any outstanding amounts under the Credit Facility
may be accelerated and Heritage Bank’s commitment to extend credit under the Heritage Bank Loan Agreement may be terminated.
The Heritage Bank Loan Agreement contains other representations and warranties, covenants, and other provisions customary to transactions
of this nature. As of September 30, 2017, the Company was in compliance with all financial covenants. The outstanding balance on
the Credit Facility was $79,953 and $1,062,129 at September 30, 2017 and December 31, 2016, respectively. The remaining available
borrowing capacity was approximately $1,304,000 and $107,000 at September 30, 2017 and December 31, 2016, respectively.

On
March 28, 2017, the Company and the Company’s wholly-owned subsidiary, EthoStream, entered into an Asset Purchase Agreement
with DCI-Design Communications LLC (“DCI”), whereby DCI would acquire all of the assets and certain liabilities of
EthoStream. Heritage Bank had provided the Company with its consent to the sale transaction. Upon closing of the sale transaction
on March 29, 2017, the entire balance outstanding on the Credit Facility was repaid. On March 29, 2017 an amendment to the
Credit Facility was executed amending the quarterly and year to date EBITDA compliance measurements
for 2017.

14

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

On August 29, 2017, an amendment to the
Credit Facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement allowing for the issuance
of corporate credit cards providing credit not to exceed $100,000. The Borrower may request credit advances in an aggregate outstanding
amount not to exceed the borrowing limits set forth in the amendment.

On October 23, 2017, an amendment to the
revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the
terms of the amendment was that if the Company deviates from its projected EBITDA for the quarters ended September 30, 2017 or
December 31, 2017, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted
cash maintained at Heritage Bank is in excess of $5,000,000. The amendment also extends the revolving credit facility’s maturity
date by one year to September 30, 2019.

NOTE F – PREFERRED STOCK

Series A

The Company has designated 215 shares of
preferred stock as Series A Preferred Stock (“Series A”). Each share of Series A is convertible, at the option of the
holder thereof, at any time, into shares of the Company’s common stock at a conversion price of $0.363 per share. On November
16, 2009, the Company sold 215 shares of Series A with attached warrants to purchase an aggregate of 1,628,800 shares of the Company’s
common stock at $0.33 per share. The Series A shares were sold at a price per share of $5,000 and each Series A share is convertible
into approximately 13,774 shares of common stock at a conversion price of $0.363 per share. The Company received $1,075,000 from
the sale of the Series A shares. In prior years, 30 of the preferred shares issued on November 16, 2009 were converted to shares
of the Company’s common stock. In a prior year, the redemption feature available to the Series A holders expired.

Series B

The Company has designated 538 shares of
preferred stock as Series B Preferred Stock (“Series B”). Each share of Series B is convertible, at the option of the
holder thereof, at any time, into shares of the Company’s common stock at a conversion price of $0.13 per share. On
August 4, 2010, the Company sold 267 shares of Series B with attached warrants to purchase an aggregate of 5,134,626 shares of
the Company’s common stock at $0.13 per share. The Series B shares were sold at a price per share of $5,000 and each
Series B share was convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company
received $1,335,000 from the sale of the Series B shares on August 4, 2010. On April 8, 2011, the Company sold 271 additional
shares of Series B with attached warrants to purchase an aggregate of 5,211,542 shares of the Company’s common stock at $0.13
per share. The Series B shares were sold at a price per share of $5,000 and each Series B share was convertible into approximately
38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,355,000 from the sale of the Series
B shares on April 8, 2011. In prior years, 486 of the preferred shares issued on August 4, 2010 and April 8, 2011 were converted
to shares of the Company’s common stock. In a prior year, the redemption feature available to the Series B holders expired.

Preferred stock carries certain preference
rights as detailed in the Company’s Amended Articles of Incorporation related to both the payment of dividends and as to
payments upon liquidation in preference to any other class or series of capital stock of the Company. As of September 30, 2017,
the liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of $409,009,
which includes cumulative accrued unpaid dividends of $149,009, and second, Series A with a preference value of $1,507,481, which
includes cumulative accrued unpaid dividends of $582,481. As of December 31, 2016, the liquidation preference of the preferred
stock is based on the following order: first, Series B with a preference value of $393,435, which includes cumulative accrued unpaid
dividends of $133,435, and second, Series A with a preference value of $1,452,114, which includes cumulative accrued unpaid dividends
of $527,114.

15

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

NOTE G – CAPITAL STOCK

The Company has authorized 15,000,000 shares
of preferred stock (designated and undesignated), with a par value of $.001 per share. The Company has designated 215 shares as
Series A preferred stock and 538 shares as Series B preferred stock. As of September 30, 2017 and December 31, 2016, there were
185 shares of Series A and 52 shares of Series B outstanding.

The Company has authorized 190,000,000
shares of common stock with a par value of $.001 per share. As of September 30, 2017 and December 31, 2016 the Company had 133,440,111
and 132,774,475 common shares issued and outstanding.

During the nine months ended September
30, 2016, 5,211,542 warrants were exercised for an aggregate of 5,211,542 shares of the Company’s common stock at $0.13 per
share. These warrants were originally granted to shareholders of the April 8, 2011 Series B preferred stock issuance.

During the nine months ended September
30, 2016, 3 shares of Series B preferred stock were converted to, in aggregate, 115,385 shares of common stock.

NOTE H – STOCK OPTIONS
AND WARRANTS

Employee Stock Options

The Company maintains an equity incentive
plan, (the “Plan”). The Plan was established in 2010 as an incentive plan for officers, employees, non-employee directors,
prospective employees and other key persons. It is anticipated that providing such persons with a direct stake in the Company’s
welfare will assure a better alignment of their interests with those of the Company and its stockholders.

The following table summarizes the changes
in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company
under the Plan as of September 30, 2017.

The expected life of awards granted represents
the period of time that they are expected to be outstanding. The Company determines the expected life based on historical experience
with similar awards, giving consideration to the contractual terms, vesting schedules, exercise patterns and pre-vesting and post-vesting
forfeitures. The Company estimates the volatility of the Company’s common stock based on the calculated historical volatility
of the Company’s own common stock using the trailing 24 months of share price data prior to the date of the award. The Company
bases the risk-free interest rate used in the Black-Scholes option valuation model on the implied yield currently available on
U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award. The Company has not
paid any cash dividends on the Company’s common stock and does not anticipate paying any cash dividends in the foreseeable
future. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes option valuation model. The Company
uses historical data to estimate pre-vesting option forfeitures and record share-based compensation for those awards that are expected
to vest. In accordance with ASC 718-10, the Company adjusts share-based compensation for changes to the estimate of expected equity
award forfeitures based on actual forfeiture experience.

There were 3,000,000 and zero options granted
and zero options exercised during the nine months ended September 30, 2017 and 2016, respectively. Total stock-based compensation
expense in connection with options granted to employees recognized in the condensed consolidated statements of operations for the
three and nine months ended September 30, 2017 and 2016 was $2,343 and $2,703, respectively, and $320,545 and $10,204, respectively.

Warrants

The following table summarizes the changes
in warrants outstanding and the related prices for the shares of the Company’s common stock issued to non-employees of the
Company.

Warrants Outstanding

Warrants Exercisable

Exercise Prices

Number

Outstanding

Weighted Average

Remaining

Contractual Life

(Years)

Weighted Average

Exercise Price

Number

Exercisable

Weighted Average

Exercise Price

$

0.18

50,000

0.16

$

0.18

50,000

$

0.18

0.20

250,000

4.02

0.20

250,000

0.20

300,000

3.38

$

0.20

300,000

$

0.20

17

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

Transactions involving warrants are summarized as follows:

Number of Shares

Weighted Average Price Per Share

Outstanding at January 1, 2016

5,638,410

$

0.20

Issued

–

–

Exercised

(5,211,542

)

0.13

Cancelled or expired

(126,868

)

3.00

Outstanding at December 31, 2016

300,000

0.20

Issued

–

–

Exercised

–

–

Cancelled or expired

–

–

Outstanding at September 30, 2017

300,000

$

0.20

There were no warrants granted, exercised,
cancelled or forfeited during the nine months ended September 30, 2017 and no warrants granted, 5,211,542 warrants exercised and
126,868 cancelled or forfeited during the nine months ended September 30, 2016, respectively.

NOTE I – RELATED PARTY
TRANSACTIONS

On August 4, 2016, the Board of Directors
authorized the Company to reimburse Peter T. Kross (“Mr. Kross”) $161,075 for expenses incurred related to his successful
contested proxy. Effective June 27, 2016, Mr. Kross became a director of the Company and is considered a related party. On August
30, 2016, Mr. Kross accepted an unsecured promissory note (“Kross Note”) for $161,075 from the Company. The outstanding
principal balance bore interest at the annual rate of 3.00%. Payment of interest and principal began on September 1, 2016 and continued
monthly on the first day of each month thereafter through and including June 1, 2017. The Company was required to pay equal monthly
installments of $16,330 which included all remaining principal and accrued interest owed by the Company to Mr. Kross under the
Kross Note. The Company could prepay in advance any unpaid principal or interest due under the Kross Note without premium or penalty.
The principal balance of the Kross Note as of September 30, 2017 and December 31, 2016 was zero and $97,127, respectively.

During the nine months ended September
30, 2017, the Company issued common stock in the amount of $108,000 to the Company’s non-employee directors as compensation
for their attendance and participation in the Company’s Board of Director and committee meetings.

On July 1, 2016, each newly elected Board
of Director member, Mr. Kross, Mr. Blatt and Mr. Byrnes were granted 100,000 stock options pursuant to the Company’s Board
of Director compensation plan. These options have an expiration period of ten years, vest quarterly over five years and have an
exercise price of $0.19.

Upon execution of their employment agreements
during the nine months ended September 30, 2017, each of Messrs. Tienor, Sobieski and Koch, were granted 1,000,000 stock options
at fair market value and all were scheduled to vest over a three year period. However, pursuant to the terms of the employment
agreements, the stock options vested immediately upon the sale of the Company’s subsidiary, EthoStream, in March 2017.

During the nine months ended September
30, 2017, Messrs. Tienor, Sobieski and Koch, earned a bonus of $29,250 contingent on the sale and sale price amount of Ethostream.

From time to time the Company may receive
advances from certain of its officers in the form of salary deferment or cash advances to meet short term working capital needs.
These advances may not have formal repayment terms or arrangements. As of September 30, 2017 and December 31, 2016, there were
no such arrangements.

18

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

NOTE J – COMMITMENTS AND CONTINGENCIES

Office Lease Obligations

In October 2013, the Company entered into
a lease agreement for 6,362 square feet of commercial office space in Waukesha, Wisconsin for its corporate headquarters. The Waukesha
lease would have expired in April 2021, but was subsequently amended and extended through April 2026. On April 7, 2017 the Company
executed an amendment to its’ existing lease in Waukesha, Wisconsin to expand another 3,982 square feet, bringing the total
leased space to 10,344 square feet. In addition, the lease term was extended from May 1, 2021 to April 30, 2026. The commencement
date for this amendment was July 15, 2017.

In January 2016, the Company entered into
a lease agreement for 2,237 square feet of commercial office space in Germantown, Maryland for its Maryland employees. The Germantown
lease was set to expire at the end of January 2017. In December 2016, the Company entered into a first amendment to the lease agreement
extending the lease through the end of January 2018.

In May 2017, the Company entered into a
lease agreement for 5,838 square feet of floor space in Waukesha, Wisconsin for its inventory warehousing operations. The Waukesha
lease expires in May 2027.

Commitments for minimum rentals under non-cancelable
leases as of September 30, 2017 are as follows:

2017 (remainder of)

$

43,738

2018

153,063

2019

154,496

2020

164,903

2021

182,512

2022 and thereafter

764,024

Total

$

1,462,736

Rental expenses charged to continuing operations
for the three and nine months ended September 30, 2017 and 2016 was $86,649 and $42,271 and $200,816 and $127,537, respectively.

Litigation

The Company is subject to legal proceedings
and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements may occur,
the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position,
results of operations or liquidity.

Sales Tax

During 2012, the Company engaged a sales
tax consultant to assist in determining the extent of its potential sales tax exposure. Based upon this analysis, management determined
the Company had probable exposure for certain unpaid obligations, including interest and penalty, of approximately $1,100,000 including
and prior to the year ended December 31, 2011. The Company has approximately $72,000 and $275,000 accrued as of September 30, 2017
and December 31, 2016, respectively.

During the
year ended December 31, 2016, the State of Wisconsin performed a sales and use tax audit covering the period from January 1, 2012
through December 31, 2015. The audit resulted in approximately $120,000 in additional use tax and interest. As of September 30,
2017, the Company paid in full the additional use tax liability and interest associated with the sales and use tax audit.

19

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

Prior to 2017, the Company successfully
executed and paid in full VDAs in thirty six states totaling approximately $765,000 and is current with the subsequent filing requirements.

The following table sets forth the change in the sales tax accrual
as of September 30, 2017 and December 31, 2016:

September 30,

2017

December 31, 2016

Balance, beginning of year

$

274,869

$

229,768

Sales tax collected

235,091

452,016

Provisions (reversals)

(52,000

)

151,000

Interest and penalties

-

(3,017

)

Payments

(385,629

)

(554,898

)

Balance, end of period

$

72,331

$

274,869

NOTE K – BUSINESS CONCENTRATION

For the nine months ended September 30,
2017 and 2016, no single customer represented 10% or more of total net revenues. As of September 30, 2017, one customer accounted
for approximately 10% of the Company’s net accounts receivable. As of December 31, 2016, two customers accounted for approximately
24% of the Company’s net accounts receivable.

Purchases from one supplier approximated
$2,122,000, or 86%, of purchases for the nine months ended September 30, 2017 and $1,907,000, or 77%, of purchases for the nine
months ended September 30, 2016. Total due to this supplier, net of deposits, was approximately $525,858 as of September 30, 2017,
and $45,037 as of December 31, 2016.

NOTE L – DISCONTINUED OPERATIONS

In October of 2016, the Company, under
the direction and authority of the Board of Directors, committed to a plan to offer for sale EthoStream, the Company’s wholly–owned
High-Speed Internet Access (“HSIA”) subsidiary. As a result of this decision to sell EthoStream, the operating
results of EthoStream as of and for the year ended December 31, 2016 were reclassified as discontinued operations and as assets
and liabilities held for sale in the consolidated financial statements as detailed in the table below. During the nine months ended
September 30, 2017, the Company, and EthoStream, entered into an Asset Purchase Agreement (the “Purchase Agreement”)
with DCI-Design Communications LLC (“DCI”), a Delaware limited liability company, whereby DCI acquired all of the assets
and certain liabilities of EthoStream for a base purchase price of $12,750,000. The Purchase Agreement includes that proceeds
of $900,000 are to be withheld from the $12,750,000 base purchase price and placed into an escrow account to support potential
indemnification obligations of up to $800,000 and net working capital adjustments of up to $100,000. The escrow amount, net of
potential claims, would be fully released after an escrow period not to exceed 12 months after closing. Another $93,000 is classified
in other current assets as a net working capital receivable. The assets included, among other items, certain inventory, contracts
and intellectual property. DCI acquired only the liabilities provided for in the Purchase Agreement. On March 29, 2017,
pursuant to the terms and the conditions of the Purchase Agreement, the Company closed on the sale.

On September 27, 2017, the Company reached
a final settlement with DCI on net working capital as set forth in the Purchase Agreement. On September 29, 2017, the Company received
$100,000 from the escrow account for the portion of the escrow account set aside for net working capital adjustments and cash proceeds
of $311,000 from DCI in the settlement of net working capital adjustments. The net working capital receivable of $93,000 in other
current assets was applied against the cash proceeds of $311,000 received on September 29, 2017 resulting in a gain from sale of
discontinued operations of $218,000 recognized during the three months ended September 30, 2017.

20

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

The following table summarizes the balance
sheet information for discontinued operations.

September 30,

December 31,

2017

2016

Accounts receivable, net

$

–

$

456,478

Inventories

–

350,506

Other current assets

–

12,980

Other asset – goodwill

–

5,796,430

Other asset – intangible asset, net

–

533,577

Current assets of discontinued operations

–

7,149,971

Accounts payable

–

465,346

Accrued liabilities and expenses

–

90,187

Deferred revenues

–

37,509

Customer deposits

–

200,466

Deferred lease liability

–

76,096

Current liabilities of discontinued operations

–

869,604

Net assets of discontinued operations

$

–

$

6,280,367

The following table summarizes the statements
of operations information for discontinued operations.

Three Months Ended

September 30,

Nine Months Ended

September 30,

2017

2016

2017

2016

Revenues, net:

Product

$

–

$

995,425

$

653,839

$

2,749,001

Recurring

–

1,038,585

925,837

2,985,550

Total Net Revenue

–

2,034,010

1,579,676

5,734,551

Cost of Sales:

Product

(11,600

)

565,276

403,004

1,753,994

Recurring

–

242,678

209,868

697,541

Total Cost of Sales

(11,600

)

807,954

612,872

2,451,535

Gross Profit

11,600

1,226,056

966,804

3,283,016

Operating Expenses:

Selling, general and administrative

197

315,437

252,307

896,385

Depreciation and amortization

–

60,420

60,420

181,697

Total Operating Expenses

197

375,857

312,727

1,078,082

Income from Discontinued Operations before Provision for Income Taxes

11,403

850,199

654,077

2,204,934

Provision for Income Taxes

–

51,312

52,017

153,936

Income from Discontinued Operations (net of tax)

$

11,403

$

798,887

$

602,060

$

2,050,998

21

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

The consolidated statements of cash flows
do not present the cash flows from discontinued operations for investing activities or financing activities because there were
no investing or financing activities associated with the discontinued operations in three and nine months ended September 30, 2017
and 2016.

NOTE M - SUBSEQUENT EVENT

On October 24, 2017, the Company announced
a share repurchase program authorized by its Board of Directors. The share repurchase program does not obligate the Company to
acquire any specific number of shares, but authorizes the Company to repurchase up to ten million shares of the Company’s
common stock. Under the program, shares may be repurchased in privately negotiated and/or open market transactions. The program
does not have a specific expiration date and may be suspended or discontinued at any time. As of the date of this filing, no shares
have been repurchased under the program.

22

Item 2. Management’s Discussion and Analysis of
Financial Condition and Results of Operations

The following discussion and analysis of
the Company’s financial condition and results of operations should be read in conjunction with the accompanying condensed
consolidated financial statements and related notes thereto for the three and nine months ended September 30, 2017, as well as
the Company’s consolidated financial statements and related notes thereto and management’s discussion and analysis
of financial condition and results of operations in the Company’s Form 10-K for the year ended December 31, 2016, filed with
the U.S. Securities and Exchange Commission (the “SEC”) on April 3, 2017.

Business

Telkonet, Inc. (the “Company”,
“Telkonet”, “we”, “our”), formed in 1999 and incorporated under the laws of the state of Utah,
is the creator of the EcoSmart Platform of intelligent automation solutions designed to optimize energy efficiency, comfort and
analytics in support of the emerging Internet of Things (“IoT”).

In October of 2016, the Company, under
the direction and authority of the Board of Directors, committed to a plan to offer for sale EthoStream LLC (“EthoStream”),
its wholly-owned High-Speed Internet Access (“HSIA”) subsidiary. The sale will enable the Company to focus on
its higher growth potential EcoSmart Platform line. As a result of this decision to sell EthoStream, the operating results of EthoStream
for the three and nine months ended September 30, 2017 and 2016 have been reclassified as discontinued operations in the condensed
consolidated statement of operations and as assets and liabilities of discontinued operations in the condensed consolidated balance
sheet for the year ended December 31, 2016. The transaction closed on March 29, 2017.

The Company’s direct sales effort
targets the hospitality, education, commercial, utility and government/military markets. Taking advantage of legislation, including
the Energy Independence and Security Act of 2007, or EISA, the Energy Policy Act of 2005, and the American Recovery and Reinvestment
Act the Company is focusing its sales efforts in areas with available public funding and incentives, such as rebate programs offered
by utilities for efficiency upgrades. Through the Company’s proprietary platform, technology and partnerships with energy
efficiency providers, the Company’s management intends to position the Company as a leading provider of energy management
solutions.

Forward-Looking Statements

In accordance with the Private Securities
Litigation Reform Act of 1995, the Company can obtain a “safe-harbor” for forward-looking statements by identifying
those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual
results to differ materially from those in the forward-looking statements. Accordingly, the following “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” may contain certain forward-looking statements
regarding strategic growth initiatives, growth opportunities and management’s expectations regarding orders and financial
results for the remainder of 2017 and future periods. These forward-looking statements are based on current expectations and current
assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause
actual results to differ materially from any future results encompassed within the forward-looking statements. Factors
that could cause or contribute to such differences include those risks affecting the Company’s business as described in the
Company’s filings with the SEC, including the current reports on Form 8-K, which factors are incorporated herein by reference.
The Company expressly disclaims a duty to provide updates to forward-looking statements, whether as a result of new information,
future events or other occurrences.

Critical Accounting Policies and
Estimates

The preparation of financial statements
in conformity with accounting principles generally accepted in the United States of America requires the Company to make estimates
and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. On
an ongoing basis, the Company evaluates significant estimates used in preparing its condensed consolidated financial statements
including those related to revenue recognition and allowances for uncollectible accounts receivable, inventory obsolescence, depreciation
and amortization, long-lived asset valuations, impairment assessments, taxes and related valuation allowance, income tax provisions,
stock-based compensation, and contingencies. The Company bases its estimates on historical experience, underlying run rates and
various other assumptions that the Company believes to be reasonable, the results of which form the basis for making judgments
about the carrying values of assets and liabilities. Actual results could differ from these estimates. The following are critical
judgments, assumptions, and estimates used in the preparation of the condensed consolidated financial statements.

23

Revenue Recognition

For revenue from product sales, the
Company recognizes revenue in accordance with ASC 605-10, “Revenue Recognition” and ASC 605-10-S99 guidelines
that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably
assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the
selling prices of the products delivered and the collectability of those amounts. Assuming all conditions for revenue
recognition have been satisfied, product revenue is recognized when products are shipped and installation revenue is
recognized when the services are completed. Provisions for discounts and rebates to customers, estimated returns and
allowances, and other adjustments are provided for in the same period the related sales are recorded. The guidelines also
address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or
rights to use assets.

Multiple-Element Arrangements (“MEAs”):
The Company accounts for contracts that have both product and installation under the MEAs guidance in ASC 605-25. Arrangements
under such contracts may include multiple deliverables consisting of a combination of equipment and services. The deliverables
included in the MEAs are separated into more than one unit of accounting when (i) the delivered equipment has value to the
customer on a stand-alone basis, and (ii) delivery of the undelivered service element(s) is probable and substantially in
the Company’s control. Arrangement consideration is then allocated to each unit, delivered or undelivered, based
on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”)
if it exists, second on third-party evidence (“TPE”) if it exists and on estimated selling price (“ESP”)
if neither VSOE or TPE exist.

•

VSOE – In most instances, products are sold separately in stand-alone arrangements. Services are also sold separately through renewals of contracts with varying periods. The Company determines VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s).

•

TPE – If the Company cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, the Company uses third-party evidence of selling price. The Company determines TPE based on sales of a comparable amount of similar product or service offered by multiple third parties considering the degree of customization and similarity of product or service sold.

•

ESP – The estimated selling price represents the price at which the Company would sell a product or service if it were sold on a stand-alone basis. When neither VSOE nor TPE exists for all elements, the Company determines ESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on the Company’s pricing practices. Adjustments for other market and Company-specific factors are made as deemed necessary in determining ESP.

Under the estimated selling price method,
revenue is recognized in MEAs based on estimated selling prices for all of the elements in the arrangement, assuming all other
conditions for revenue recognition have been satisfied. To determine the estimated selling price, the Company establishes
the selling price for its products and installation services using the Company’s established pricing guidelines, and the
proceeds are allocated between the elements and the arrangement.

When MEAs include an element of customer
training, the Company determined it is not essential to the functionality, efficiency or effectiveness of the MEA due to its perfunctory
nature in relation to the entire arrangement. Therefore the Company has concluded that this obligation is inconsequential and perfunctory.
As such, for MEAs that include training, customer acceptance of said training is not deemed necessary in order to record the related
revenue, but is recorded when the installation deliverable is fulfilled. Historically, training revenues have not been significant.

24

The Company provides call center support
services to properties installed by the Company. The Company receives monthly service fees from such properties for its services.
The Company recognizes the service fee ratably over the term of the contract. The prices for these services are fixed and determinable
prior to delivery of the service. The fair value of these services is known due to objective and reliable evidence from standalone
executed contracts. The Company reports such revenues as recurring revenues. Deferred revenue includes deferrals for
the monthly support service fees. Long-term deferred revenue represents support service fees to be earned or provided beginning
after September 30, 2018. Revenue recognized that has not yet been billed to a customer results in an asset as of the end of the
period. As of September 30, 2017 and December 31, 2016, there was $68,855 and $193,400 recorded within accounts receivable, respectively,
related to revenue recognized that has not yet been billed.

New Accounting Pronouncements

For information regarding recent accounting
pronouncements and their effect on the Company, see “New Accounting Pronouncements” in Note B of the Notes to Unaudited
Condensed Consolidated Financial Statements contained herein.

Product revenue principally arises from
the sale and installation of the EcoSmart energy management platform. The EcoSmart Suite of products consists of thermostats, sensors,
controllers, wireless networking products switches, outlets and a control platform.

For the three months ended
September 30, 2017, product revenue increased by 40% or $0.5 million and for the nine months ended September 30, 2017,
product revenue decreased 10% or $0.6 million. For the three months ended September 30, 2017, the hospitality market
comprised $1.3 million of product sales for the three months ended September 30, 2017, a $0.1 million decrease from the prior
year period. The education market sales for the three months ended September 30, 2017 increased $0.3 million to $0.4 million
from $0.1 million for the prior year period. The Multiple Dwelling Unit (“MDU”) market increased $0.2 million
from $0.0 million during the three months ended September 30, 2016. The hospitality market sales for the nine months ended
September 30, 2017 decreased $0.7 million to $4.2 million from $4.9 million for the prior year period. The education market
sales for the nine months ended September 30, 2017 increased $0.1 million to $1.0 million from $0.9 million for the prior
year period and the Commercial and MDU market sales for the nine months ended September 30, 2017 remained at $0.5 million for
the nine months ended September 30, 2017 and 2016. The Company’s distribution channels through resellers and value
added distribution partners decreased from $3.1 million for the nine months ended September 30, 2016 to $2.8 million at
September 30, 2017.

25

Recurring Revenue

Recurring revenue is attributed to our
call center support services. The Company recognizes revenue ratably over the service month for monthly support revenues and defers
revenue for annual support services over the term of the service period. Recurring revenue consists of Telkonet’s EcoCare
service and support program.

For the three and nine months ended September
30, 2017, recurring revenue decreased by 8% and increased by 1%, respectively, when compared to the prior year period.

Cost of Sales

Three Months Ended

September 30, 2017

September 30, 2016

Variance

Product

$

1,160,019

61%

$

770,830

57%

$

389,189

50%

Recurring

55,702

42%

36,618

26%

19,084

52%

Total

$

1,215,721

60%

$

807,448

54%

$

408,273

51%

Nine Months Ended

September 30, 2017

September 30, 2016

Variance

Product

$

3,233,978

56%

$

3,194,094

50%

$

39,884

1%

Recurring

118,347

34%

92,324

27%

26,023

28%

Total

$

3,352,325

55%

$

3,286,418

49%

$

65,907

2%

Costs of Product Revenue

Costs of product revenue include equipment
and installation labor related to EcoSmart technology. For the three and nine months ended September 30, 2017, product costs
increased by 50% and 1%, respectively, compared to the prior year periods. For the three month comparison, the materials costs
as a percentage of product sales increased 2% to 45% for the three month ended September 30, 2017 from 43% for the three months
ended September 30, 2016. The cost of materials increased $0.15 million, freight and warranty expense increased $0.04 million and
inventory adjustments increased $0.08 million. For the three months ended September 30, 2017, the Company’s increased use
of outside contractors for installations resulted in a $0.19 million variance in contractor services costs, consequently, salary,
benefits and travel costs related to installations decreased by $0.07 million.

For the nine month comparison, the use
of outside contractors for installations resulted in a $0.20 million decrease in salary, wages and travel expense. These decreases
were offset by a $0.16 million adjustment in inventory costs, a $0.03 million increase in freight costs, a $0.03 million increase
in outside services and a $0.02 million increase in parts and supplies and warranty expense.

Costs of Recurring Revenue

Recurring costs are comprised of labor
and telecommunication services for our customer service department. For the three and nine months ended September 30, 2017,
recurring costs increased by 52% and 28%, respectively, when compared to the prior year periods. The three and nine month variances
are the result of a $0.02 million and a $0.03 million increase in salary and benefit costs for the period ended September 30, 2017.
The Company added a support services supervisor.

26

Gross Profit

Three Months Ended

September 30, 2017

September 30, 2016

Variance

Product

$

744,552

39%

$

590,057

43%

$

154,495

26%

Recurring

75,963

58%

106,410

74%

(30,447

)

-29%

Total

$

820,515

40%

$

696,467

46%

$

124,048

18%

Nine Months Ended

September 30, 2017

September 30, 2016

Variance

Product

$

2,494,900

44%

$

3,162,343

50%

$

(667,443

)

-21%

Recurring

226,361

66%

248,088

73%

(21,727

)

-9%

Total

$

2,721,261

45%

$

3,410,431

51%

$

(689,170

)

-20%

Gross Profit on Product Revenue

Gross profit for the three and nine months
ended September 30, 2017 increased by 26% and decreased by 21%, respectively, when compared to the prior year periods. For the
three months ended September 30, 2017, the actual gross profit percentage declined to 39% from 43%. The majority of the variance
was due to an approximate increase of 20% for outside services. For the nine months ended September 30, 2017, the actual gross
profit percentage declined to 44% from 50%. Material costs as a percentage of sales increased 3% for the nine months ended September
30, 2017 when compared to the prior year period. The inventory valuation adjustment variance of $0.16 million during the nine months
ended September 30, 2017 when compared to the prior year period also contributed to gross profit decline.

Gross Profit on Recurring Revenue

The gross profit associated with recurring
revenue decreased by 29% and 9%, respectively, for the three and nine months ended September 30, 2017 when compared to the prior
year periods. For the three months ended September 30, 2017, the actual gross profit percentage decreased 16% compared to
the prior year period, from 74% to 58%. The primary reason was a manager was added to the Company’s support department, increasing
wages and benefits. For the nine months ended September 30, 2017, the actual gross profit percentage decreased 7% compared to the
prior year period, from 73% to 66%.

Operating Expenses

Three Months Ended September 30,

2017

2016

Variance

Total

$

1,704,177

$

1,870,493

$

(166,316

)

-9%

Nine Months Ended September 30,

2017

2016

Variance

Total

$

5,754,741

$

6,357,622

$

(602,881

)

-9%

27

During the three and nine months ended
September 30, 2017, operating expenses decreased by 9% when compared to the prior year periods as outlined below.

Research and Development

Three Months Ended September 30

2017

2016

Variance

Total

$

500,656

$

429,622

$

71,034

17%

Nine Months Ended September 30,

2017

2016

Variance

Total

$

1,323,669

$

1,321,007

$

2,662

0%

Research and development costs are
related to both present and future products and are expensed in the period incurred. Current research and development costs
are associated with product development and integration. During the three and nine months ended September 30, 2017, research
and development costs increased by 17% and 0%, respectively, when compared to the prior year periods. For the three month
comparison, the variance is due to an approximate $0.04 million increase in expenditures for consulting, a $0.01 increase in
personnel recruiting and an increase of $0.02 million for salary and benefits. For the nine month comparison, overall expense
remained unchanged however there were changes within the research and development category. For the nine months ended
September 30, 2017, a $0.06 million decrease was the result of retooling charges related to new product development for the
prior year period. This was offset by a $0.04 million increase in consulting and a $0.02 million increase for new product
certification expenses for the nine months ended September 30, 2017.

Selling, General and Administrative Expenses

Three Months Ended September 30,

2017

2016

Variance

Total

$

1,188,905

$

1,432,489

$

(243,584)

-17%

Nine Months Ended September 30,

2017

2016

Variance

Total

$

4,396,667

$

5,012,249

$

(615,582)

-12%

During the three and nine months
ended September 30, 2017, selling, general and administrative expenses decreased over the prior year periods by 17% and 12%,
respectively. For the three month comparison, due to the sale of EthoStream, the Company was able to decrease executive,
accounting and sales salaries, wages and benefits by $0.20 million. A $0.07 million decrease was a result of a refund
received from a utility. The Company had a $0.09 million decrease in sales and use tax, the result of a $0.10 million State
of Wisconsin audit assessment during 2016 as well as a $0.06 million decrease in bad debt expense, the result of a collection
previously reserved. These decreases were offset by increases for legal expense of $0.03 million, hardware/software
expenses of $0.06 million, marketing and trade show expense of $0.05 million, rent expense of $0.04 million and commissions
of $0.02 million.

For the nine month comparison, $0.29
million of the variance is attributed to the costs associated with the contested 2016 proxy contest as discussed in detail in
the June 30, 2017 Form 10-Q as well as an additional $0.10 million in public company fees in 2016. Due to the sale
of EthoStream, the Company was able to decrease temporary staffing, executive, accounting and sales salaries, wages and
benefits of $0.61 million, $0.11 million for sales and use tax, related to the State of Wisconsin audit discussed above, a
utility refund of $0.07 million, $0.03 million for director fees, $0.04 million for insurance expense. These reductions in
expense were offset by an increase in stock option expense of $0.31 million, marketing and trade show expenses of $0.14
million, rent expense of $0.07 million, commissions of $0.02 million and hardware/software costs of $0.05 million.

28

Income from Discontinued Operations, Net of Tax

Three Months Ended September 30,

2017

2016

Variance

Total

$

11,403

$

798,887

$

(787,484)

-99%

Nine Months Ended September 30,

2017

2016

Variance

Total

$

602,060

$

2,050,998

$

(1,448,938)

-71%

Income from discontinued operations
decreased $0.79 million or 99% and $1.45 million or 71% for the three and nine months ended September 30, 2017 over the prior
year periods. On March 29, 2017, pursuant to the terms and the conditions of the Purchase Agreement, the Company closed on
the sale of EthoStream. The income from discontinued operations (net of tax) represents the activity of EthoStream from January 1, 2017
through the date of the sale on March 28, 2017. After March 28, 2017, certain liabilities retained by the Company will be
adjusted in future periods as these liability balances are paid.

EBITDA from Continuing Operations

Management believes that certain non-GAAP
financial measures may be useful to investors in certain instances to provide additional meaningful comparisons between current
results and results in prior operating periods. Adjusted earnings before interest, taxes, depreciation and amortization (“Adjusted
EBITDA”) is a metric used by management and frequently used by the financial community. Adjusted EBITDA provides insight
into an organization’s operating trends and facilitates comparisons between peer companies, since interest, taxes, depreciation
and amortization can differ greatly between organizations as a result of differing capital structures and tax strategies. Adjusted
EBITDA is one of the measures used for determining our debt covenant compliance. Adjusted EBITDA excludes certain items that are
unusual in nature or not comparable from period to period. While management believes that non-GAAP measurements are useful supplemental
information, such adjusted results are not intended to replace our GAAP financial results. Adjusted EBITDA is not, and should not
be considered, an alternative to net income (loss), income (loss) from operations, or any other measure for determining operating
performance of liquidity, as determined under accounting principles generally accepted in the United States (GAAP). In assessing
the overall health of its business for the three and nine months ended September 30, 2017 and 2016, the Company excluded items
in the following general category described below:

·

Stock-based compensation: The Company believes that because of the variety of equity awards used by companies, varying methodologies for determining stock-based compensation and the assumptions and estimates involved in those determinations, the exclusion of non-cash stock-based compensation enhances the ability of management and investors to understand the impact of non-cash stock-based compensation on our operating results. Further, the Company believes that excluding stock-based compensation expense allows for a more transparent comparison of its financial results to the previous period.

·

Bonuses paid to executives upon sale of discontinued operations: The Company does not consider the bonuses of $87,750 associated with the sale of EthoStream to be indicative of current or future operating performance. Therefore, the Company does not consider the inclusion of these costs helpful in assessing its current financial performance compared to the previous year.

29

RECONCILIATION OF NET LOSS FROM

CONTINUING OPERATIONS TO ADJUSTED EBITDA

(Unaudited)

Three Months Ended

September 30,

Nine Months Ended

September 30,

2017

2016

2017

2016

Net loss from continuing operations

$

(871,340

)

$

(1,192,083

)

$

(3,034,984

)

$

(2,995,699

)

Interest (income) expense, net

(8,722

)

15,482

(2,797

)

45,308

Provision (benefit) for income taxes

(3,600

)

2,575

4,301

3,200

Depreciation and amortization

14,616

8,382

34,405

24,366

EBITDA – continuing operations

(869,046

)

(1,165,644

)

(2,999,075

)

(2,922,825

)

Adjustments:

Stock-based compensation

2,343

2,703

320,545

10,204

Bonuses paid to executives upon sale of discontinued operations

–

–

87,750

–

Adjusted EBITDA

$

(866,703

)

$

(1,162,941

)

$

(2,590,780

)

$

(2,912,621

)

Liquidity and Capital Resources

The Company has financed its operations
since inception primarily through private and public offerings of the Company’s equity securities, the issuance of various
debt instruments and asset based lending, and the sale of assets.

Working Capital

Working capital (current assets in excess
of current liabilities) from continuing operations increased by $9,840,658 during the nine months ended September 30, 2017 from
working capital deficit of $26,859 at December 31, 2016 to working capital of $9,813,799 at September 30, 2017.

Kross Promissory Note

On August 4, 2016, the Board of Directors
authorized the Company to reimburse Peter T. Kross (“Mr. Kross”) $161,075 for expenses incurred related to his successful
contested proxy. Effective June 27, 2016, Mr. Kross became a director of the Company and is considered a related party. On August
30, 2016, Mr. Kross accepted an unsecured promissory note (“Kross Note”) for $161,075 from the Company. The outstanding
principal balance bore interest at the annual rate of 3.00%. Payment of interest and principal began on September 1, 2016 and continued
monthly on the first day of each month thereafter through and including June 1, 2017. The Company was required to pay equal monthly
installments of $16,330 which included all remaining principal and accrued interest owed by the Company to Mr. Kross under the
Kross Note. The Company could prepay in advance any unpaid principal or interest due under the Kross Note without premium or penalty.
The principal balance of the Kross Note as of September 30, 2017 and December 31, 2016 was zero and $97,127, respectively.

Revolving Credit Facility

On September 30, 2014, the Company and
its wholly-owned subsidiary, EthoStream, as co-borrowers (collectively, the “Borrowers”), entered into a loan and security
agreement (the “Heritage Bank Loan Agreement”), with Heritage Bank of Commerce, a California state chartered bank (“Heritage
Bank”), governing a new revolving credit facility in a principal amount not to exceed $2,000,000 (the “Credit Facility”).
Availability of borrowings under the Credit Facility from time to time is subject to a borrowing base calculation based on the
Company’s eligible accounts receivable and eligible inventory each multiplied by an applicable advance rate, with an overall
limitation tied to the Company’s eligible accounts receivable. The Heritage Bank Loan Agreement is available for working
capital and other general business purposes. The outstanding principal balance of the Credit Facility bears interest at the Prime
Rate plus 3.00%, which was 7.25% at September 30, 2017 and 6.75% at December 31, 2016. On October 9, 2014, as part of the Heritage
Bank Loan Agreement, Heritage Bank was granted a warrant to purchase 250,000 shares of Telkonet common stock. The warrant has an
exercise price of $0.20 and expires October 9, 2021. On February 17, 2016, an amendment to the Credit Facility was executed extending
the maturity date to September 30, 2018, unless earlier accelerated under the terms of the Heritage Bank Loan Agreement.

30

The Heritage Bank Loan Agreement also contains
financial covenants that place restrictions on, among other things, the incurrence of debt, granting of liens and sale of assets.
The Heritage Bank Loan Agreement also contains financial covenants that require the Borrowers to maintain a minimum EBITDA level,
measured quarterly, and a minimum asset coverage ratio, measured monthly. A violation of any of these covenants could result in
an event of default under the Heritage Bank Loan Agreement. Upon the occurrence of such an event of default or certain other customary
events of defaults, payment of any outstanding amounts under the Credit Facility may be accelerated and Heritage Bank’s commitment
to extend credit under the Heritage Bank Loan Agreement may be terminated. The Heritage Bank Loan Agreement contains other representations
and warranties, covenants, and other provisions customary to transactions of this nature. The outstanding balance of the revolving
credit facility was $79,953 as of September 30, 2017 and the remaining available borrowing capacity was approximately $1,304,000.
As of September 30, 2017, the Company was in compliance with all financial covenants.

On
March 28, 2017, the Company and the Company’s wholly-owned subsidiary, EthoStream, entered into an Asset Purchase Agreement
with DCI-Design Communications LLC (“DCI”), whereby DCI acquired all of the assets and certain liabilities of EthoStream.
Heritage Bank provided the Company with its consent to the sale transaction. Upon closing of the sale transaction on March 29,
2017, the entire balance outstanding on the Credit Facility was repaid. On March 29, 2017 an amendment to the Credit Facility
was executed amending the quarterly and year to date EBITDA compliance measurements for 2017.

On August 29, 2017, an amendment to the
Credit Facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement allowing for the issuance
of corporate credit cards providing credit not to exceed $100,000. The Borrower may request credit advances in an aggregate outstanding
amount not to exceed the borrowing limits set forth in the amendment.

On October 23, 2017, an amendment to the
revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the
terms of the amendment was that if the Company deviates from its projected EBITDA for the quarters ended September 30, 2017 or
December 31, 2017, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted
cash maintained at Heritage Bank is in excess of $5,000,000. The amendment also extends the revolving credit facility’s maturity
date by one year to September 30, 2019.

Cash Flow Analysis

Cash used in continuing operations was
$2,459,746 and $2,768,301 during the nine months ended September 30, 2017 and 2016, respectively. As of September 30, 2017, our
primary capital needs included costs incurred to increase energy management sales, inventory procurement and managing current liabilities.
The working capital changes during the nine months ended September 30, 2017 were primarily related to an approximate $380,500 increase
in accounts receivable, a $305,000 increase in inventory, a $305,000 increase in accounts payable, a $330,000 increase
in deferred revenue and a $168,000 increase in accrued liabilities and expenses. The working capital changes during the nine months
ended September 30, 2016 were primarily related to an approximately $469,000 decrease in accounts receivable, a $410,000 increase
in inventory, a $535,000 decrease in accounts payable and a $300,000 increase in accrued liabilities and expenses. Accounts
receivable fluctuates based on the negotiated billing terms with customers and collections. We purchase inventory based on forecasts
and orders, and when those forecasts and orders change, the amount of inventory may also fluctuate. Accounts payable fluctuates
with changes in inventory levels, volume of inventory purchases, and negotiated supplier and vendor terms.

Cash
provided by investing activities was $11,092,051 during the nine months ended September 30, 2017 and cash used in investing activities
was $2,352 during the nine months ended September 30, 2016, respectively. During the nine months ended September 30, 2017, the
cash provided by investing activities reflects the proceeds less adjustments associated with the sale of the assets and certain
liabilities assumed of the Company’s wholly-owned subsidiary, EthoStream and a decrease of $142,572 associated with the purchase
of computer equipment and furniture, fixtures and equipment. Due to the sale of EthoStream, the Company extended the Waukesha lease,
as discussed in Note J, and refurbished the corporate office to accommodate employee’s previously working at the Milwaukee
operations office. During the nine months ended September 30, 2016, the Company purchased $33,629 of computer equipment and had
$31,277 of restricted cash related to a bonding requirement released.

31

Cash used in financing activities was $982,176
and cash provided by financing activities was $707,637 during the nine months ended September 30, 2017 and 2016, respectively.
The Heritage Bank Loan Agreement for the Company’s line of credit included the Company
and EthoStream as co borrowers. Upon closing the EthoStream sale transaction on March 29, 2017, the entire balance outstanding
on the Credit Facility, $1,062,129, was repaid and a net balance of $79,953 was subsequently borrowed during the three months ended
September 30, 2017. During the nine months ended September 30, 2016, 5,211,542 warrants were exercised for an aggregate of 5,211,542
shares of the Company’s common stock at $0.13 per share. These warrants were originally granted to shareholders of the April
8, 2011 Series B preferred stock issuance. Total proceeds received were $677,501. Cash used in financing activities to repay indebtedness
was $79,864 and net cash paid on the line of credit was $110,000 during the nine months ended September 30, 2016.

We are working to manage our current liabilities
while we continue to make changes in operations to improve our cash flow and liquidity position.

Management expects that global economic
conditions, in particular the decreasing price of energy, along with competition will continue to present a challenging operating
environment through 2017; therefore working capital management will continue to be a high priority for 2017. The Company’s
estimated cash requirements for our operations for the next 12 months is not anticipated to differ significantly from our present
cash requirements for our operations.

Off-Balance Sheet Arrangements

The Company has no material off-balance
sheet arrangements.

Acquisition or Disposition of Property
and Equipment

The Company does anticipate significant
purchases of property or equipment during the next twelve months. The amended and expanded Waukesha, Wisconsin lease requires furniture,
shelving, computer equipment and peripherals to be used in the Company’s day-to-day operations.

Item 4. Controls and Procedures.

As of September 30, 2017, the Company performed
an evaluation, under the supervision and with the participation of management, including the Chief Executive Officer and the Chief
Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Management has identified
control deficiencies regarding the lack of segregation of duties due to the limited size of the Company’s accounting department,
a failure to implement adequate internal control over financial reporting including in our IT general control environment, and
the need for a stronger internal control environment particularly in our financial reporting and close process. We lack sufficient
personnel resources and technical accounting and reporting expertise to appropriately address certain accounting and financial
reporting matters in accordance with generally accepted accounting principles. We did not have an adequate process or appropriate
controls in place to support the accurate reporting of our financial results and disclosures on our Form 10-Q. Management of the
Company believes that these material weaknesses are due to the small size of the Company’s accounting staff. The small size
of the Company’s accounting staff may prevent adequate controls in the future, such as segregation of duties, due to the
cost/benefit of such remediation. The Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls
and procedures were ineffective as of the end of the period covered by this report.

During the nine months ended September
30, 2017, there were no changes in the Company’s internal control over financial reporting that have materially affected,
or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

32

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

The Company is subject to legal proceedings
and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements
may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial
position, results of operations or liquidity.

Item 1A. Risk Factors.

There have been no material changes to
risk factors previously disclosed in our annual report on Form 10-K for the year ended December 31, 2016 in response to Item 1A
of Form 10-K.